Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 514

What is direct indexing?

Index funds are passive investments. They track an index with the goal of replicating the performance of that index, minus expenses. They're a popular investment choice for good reason—they’re often cheap, diversified, and uncomplicated portfolio building blocks.

Active funds, meanwhile, are led by managers who choose particular securities in an effort to outperform an index.

What is an index fund?

When you own shares of an index fund, you own the stocks in the index fund indirectly, in the same proportion as the index.

For example: Let’s say you invested $100,000 in an index fund that tracks the S&P 500.

Because the S&P 500 is tilted toward the largest companies in the market, you have some pretty sizable stakes in some of these big blue chips—nearly $6,000 in Apple (AAPL); over $5,000 in Microsoft (MSFT); $4,000 in Amazon.com (AMZN), and so on.

What does it mean to own stocks indirectly?

Indirect ownership means that even though you are exposed to the companies’ fortunes and failures, you don’t have the benefits of direct ownership.

For instance, even though you may have thousands of dollars committed to these companies, an invitation to the shareholders’ meeting will not be forthcoming. Nor do you have a say in board member elections—the portfolio manager that runs the index fund votes in shareholder elections on your behalf.

You also can’t buy and sell the underlying securities or trim any of the positions in the index fund for any reason. What if you thought Apple was overvalued and wanted to reduce your position? You’re out of luck as an index fundholder. What if Meta’s (META) data privacy and security issues give you pause, and you want to remove it from your portfolio? As an index fund investor, you are stuck holding the stock as long as it’s in the index.

How does direct indexing work?

Direct indexing means you own the stocks in the index directly. It’s a pretty straightforward idea, but most people don’t do it, and those who do are usually working with an advisor in a separately managed account.

For one thing, some indexes track areas of the market that aren’t as ‘liquid’, meaning the component securities can be thinly traded and priced inefficiently. Funds that track such indexes often use a sampling or optimisation method to mimic the performance of an index.

But even the S&P 500, which is a relatively compact index comprising very liquid (easily tradable) stocks, isn’t that easy to replicate.

One barrier to doing this, traditionally, is that you can’t buy every stock in the index if you don’t have a lot of money to invest. This is essentially why managed funds were created; they allow investors to pool their money with other investors, so they could buy hundreds or even thousands of securities and build diversified portfolios.

Two things that have made direct indexing a more viable option for more investors in recent years are the rise of commission-free trading, and fractional-share stock investing, which allows investors to purchase fractional shares in a certain dollar amount. Because stock prices vary so widely, having the ability to invest fractionally makes it much easier to match the index’s proportions.

What are the benefits of direct indexing?

When you own the stocks directly, you are ultimately the portfolio manager.

That means you can customise the index if you want to. Are there securities in the index that don’t align with your values, from an environmental, social, and governance perspective perhaps? Direct indexing allows you to sell or avoid them.

One thing to be aware of: If your version of the index starts to look a lot different from the ‘real’ index in terms of sector weightings and so on, the performance won’t match up, either. This is called tracking error.

What are the drawbacks of direct indexing?

Direct indexing really only makes sense for people who have a considerable amount to invest in a taxable account and want a level of customisation they couldn’t otherwise obtain through a portfolio of funds or individual securities.

In addition, portfolio customisation can get really complicated, really quickly. The idea of being able to customise your portfolio from an ESG or factor exposure perspective may be appealing, but keeping track of all the moving data points on 500 separate securities can be daunting.

You would also have to keep tabs on changes in the index—rebalances and reconstitutions—to make sure you know which securities are added and removed from the index.

Traditional index funds and exchange-traded funds do this for you for a (typically reasonable) annual fee.

And finally—and this is the big one, in my mind—watch out for expenses. Not only do you pay asset-based fees for the direct-indexing account, but these fees may be a multiple of what you’d pay for a diversified portfolio of ETFs or index funds, says Ben Johnson, head of client solutions for Morningstar.

Also, Johnson says, there may be frictional costs - such as brokerage commissions, bid-ask spreads, and market impact - things that you don’t really see or are difficult to measure that are involved with direct indexing.

Bear in mind that S&P 500 index trackers are low-turnover strategies, meaning they don’t buy and sell too many stocks (the portfolio turnover rate is around 4%).

The more you start trading and customising positions in a direct-indexing portfolio, the more possibilities you have to encounter transaction costs, which will ultimately eat into your return.

Is direct indexing right for you?

Direct indexing allows investors and advisors to build a portfolio that is quite different from the broad market or a broad-based index fund, Johnson explains.

Over time that may result in better risk-adjusted returns, but for many active managers, it results in worse returns. Johnson says:

“[Direct indexing] makes a large number of investors effectively active managers,”

“And what we know about active management, about being different from the market, is that sometimes it’s going to look right and feel good, and sometimes it’s going to look wrong and feel bad.”

In Johnson's opinion, this is a risk, or opportunity cost, of constructing your portfolio using direct indexing versus using traditional mutual funds or ETFs.

“There could be circumstances where [investors] would probably be better served—they would have gotten greater returns with less risk—by simply owning broad-based index mutual funds or discretionary active funds.”

 

Karen Wallace is a senior editor with morningstar.com. Firstlinks is owned by Morningstar. This article is general information and does not consider the circumstances of any investor. Originally published by Morningstar and edited slightly to suit an Australian audience.

 

Access data and research on over 40,000 securities through Morningstar Investor, as well as a portfolio manager integrated with Australia’s leading portfolio tracking service, Sharesight. Sign up to a free trial below:


Try Morningstar Investor for free


 

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.